Why We Buy Cash Flow, Not Real Estate
The one question we consistently are asked is: What markets are you investing in?!
Our response: We do not buy real estate; we buy cash flow. Rigorous execution of our process and the ability to achieve our performance targets determines the markets we enter. We strive to return to our investors a gross 20% Internal Rate of Return and 10% current cash on cash. We buy when we are confident we can hit those targets. So rather than viewing real estate as our investment, we holistically consider the factors that create, sustain and increase cash flow. Real Estate is the mechanism that creates the flow of cash and we focus on how to leverage it.
More goes into our process than just seeking yield and returns. The markets need to make economic sense, have growth drivers and a diversified economy. This process typically drives us to secondary markets, and certain specific tertiary markets with the right drivers. We identify assets where we think our return requirements can be achieved, but a viable, executable business plan with exit strategy must be created before we can commit to buying. Cash flow starts our process, extreme due diligence brings it full circle.
Building Cash Flow
The key financial component is revenue. When analyzing a potential transaction our initial focal points are the increase of revenue and cash flow.
Revenue can be derived from all aspects of the operation. In fact, 90% of the revenue from most investments is derived from Net Rental Revenue, so closely scrutinizing the spread between existing rents and market rents is essential. The remaining 10% of revenue results from “strategic operational improvements” and can be derived from such things as utility reimbursements, bulk cable deals, revenue sharing from co-branding opportunities, and storage rental units.
In a highly competitive rental market, tenants seek communities that match their lifestyle. The “amenity mix” is a significant driver in attracting and retaining our target tenant demographic, and may include a clubhouse with a kitchen and theater area, a technology/business center, playgrounds, dog parks, outdoor kitchens or fitness centers. To that end, the amenities portfolio must be “tenant-centric” and reflect an acute understanding of tenant preferences at each specific asset and create tangible value that justifies rent increases.
In some instances, amenities can also generate revenue. For example, a well-planned clubhouse can be rented to tenants for private events. Amenities qualitatively add to the lifestyle each community offers, and result in higher levels of satisfaction and higher retention rates.
Tenant engagement is also vital to retention and achieved by delivering top quality 24/7/365 customer service and being attentive to their lifestyle needs. Services such as robust resident activity schedules reflect the commitment to tenant lifestyle and help create a sense of community, while also positioning the asset more favorably in each competitive market. They also serve to sustain and increase cash flow as tenants remain through the progression of rent increases.
Is the Cash Flow Sustainable?
In assessing a potential asset, structural soundness is critical, but it does not matter if the units are run down or outdated, the property is unkempt or mismanaged, that the location is not in a gateway city. In fact, we see these issues as value add opportunities.
We primarily look at the cash that can be generated before, during, and after the transaction. Whether the capitalization rate is 4%, 6%, 8%, or 10%, is secondary in our analysis. This approach helps to adeptly identify and opportunistically acquire assets in markets that many times seem unattractive and unprofitable to others.
The addition of permanent recurring revenue increases net cash flow, which directly increases the value of the asset. Increased cash flow = increased value. Cosmetic or aesthetic enhancement, such as renovating the unit interiors, improve the tenant base and allow for increased rents, which become permanent, recurring, additional cash flow.
Is it Really Difficult to Understand and Manage?
In our approach, each asset operates as a stand-alone self-sustaining business with its own specific parameters that will impact cash flow. This approach reduces risk, which effectively causes known value in all market conditions to rise on a relative basis and ultimately makes for a sound and compelling investment thesis.
The bottom line is that this is a formulaic business unlike any other. Value is a clear and direct function of cash-flow and a function we can generally control. If we are in a 6.75% cap rate market, for every $100,000 that we increase cash flow, we increase value by $1.5 million. It is that direct tangible monetization of value that provides clarity and conviction in our asset focus.
While we welcome the question “In what markets are you investing?” equally important questions are:
- What is the cash flow now?
- What is the cash flow throughout the hold period?
- What are the three biggest risks to reduced cash flow?
- What is the terminal return?
- What are your investment objectives?
- How can you best achieve those objectives?
Our experience, process and execution enables us to avoid debating issues such as cap-rates and focus on the generation and expansion of cash flow, a bankable asset!